Mounting fears regarding the pace of interest rate hikes by the Federal Reserve, increased tensions between the U.S. and China over trade, and concerns over slowing global growth led to volatile conditions in both equity and fixed income markets during the final quarter of 2018. These fears led equities to fall 13.52% in the quarter, as measured by the S&P 500. The decline in equities during the quarter induced selling across a wide spectrum of asset classes, including high-yield bonds, which fell 4.64% and senior loans which were down 3.42%. The risk-off sentiment led to a flight to quality, notably into U.S. Treasury Bonds. As Treasury's increased in value, interest rates declined. The yield on the 10 Year U.S. Treasury Bond had its first quarterly decline since the second quarter of 2017 as the yield moved from 3.06% at the end of the third quarter to 2.68% at the end of the fourth quarter. Despite the volatility in the fourth quarter, senior loans outperformed most fixed income asset classes in 2018. Loans finished the year marginally positive at 0.47% (Exhibit 1) while high-yield bonds were down 2.25% (Exhibit 2), investment grade corporate bonds were down 2.24% and the Bloomberg Barclays Aggregate Index, a good proxy for the overall bond market, finished the year up one basis point.

The weakness continued in emerging markets for the third quarter as the JP Morgan GBI-EM Global Diversified Index (the "Index") fell -1.83%. The yield on the Index rose 3 basis points (bps) over the quarter to 6.62% while similar duration 5-yr maturity US Treasury bond yields rose 22 basis points to 2.95%.

Although yields rose modestly for the emerging market (EM) asset class, the return from local currency bonds was positive over the quarter at 0.24% due to the high carry earned on the index. Weaker emerging market currencies versus the US dollar drove the volatility over the period. Emerging market currencies contributed -2.06% to the Index return over the period.

The continued rise in US Treasury yields is a concern for fixed income investors especially when comparing US domestic fixed income to global fixed income opportunities. With rising US Treasury yields the spread between international bond yields and US domestic yields compress. The less attractive pick-up in yield on the face of it shows that foreign bonds are now more expensive or less of a value proposition, however, that may overlook some of the benefits of diversifying globally when it comes to fixed income.

US Equity ETFs received the strongest estimated net inflows in Q3 2018, for the second straight quarter, with a total of $50.4 billion, compared to $37.6 billion in Q2 2018. Estimated net inflows for Sector Equity ETFs increased to $15.3 billion in Q3 2018, rebounding from a lackluster Q2 2018.

Taxable Bond ETFs had the second highest estimated net inflows in Q3 2018 with $23.5 billion. Municipal Bond ETFs received $0.8 billion in estimated net inflows in Q3 2018. Notably, neither fixed income category has had net outflows during a calendar quarter since 2013.

¹ Source: Morningstar, as of 9/30/18. Includes all US-listed exchange-traded funds, exchange-traded notes and other exchange-traded products. All net inflow and outflow numbers are estimates based on information provided by Morningstar.

Given the magnitude of credit spread widening during the 2nd quarter, it should not be too surprising that the investment grade credit market recovered during 3Q 2018. However, given ongoing concerns about rising interest rates, trade tensions, Italian sovereign risk, and the growth of the BBB-rated segment -- the magnitude of the recovery was somewhat unexpected. The option-adjusted spread on the Bloomberg Barclays US Corporate Index tightened 17 basis points (bps) to 106 over the three month period ending September 30, 2018. This compares to 93 bps at the beginning of the year, and 101 bps at the end of 3Q 2017. In the U.S. Treasury market, the benchmark 10-year yield increased from 2.85% on June 30, 2018 to 3.057% on September 30, 2018– after having traded as high as 3.101% and as low as 2.82% during the quarter.

Most of the spread retracement occurred during July, as strong earnings combined with solid economic data to foster a "risk on" tone. Interest rates moved higher, leading to increased demand as all-in-yields (UST rate plus credit spread) become more compelling. This positive technical was helped by a muted new issue calendar. Not surprisingly, given the rally, the best performing sectors tended to be those with higher spread beta and lower credit ratings. The July snap back was the strongest monthly excess return performance for the Bloomberg Barclays U.S. Corporate Index since April 2016, though total returns were hurt by the selloff in Treasuries.

In the 3rd quarter, U.S. equity beta rewarded investors. "Buy risk," "buy on the dips," "buy growth", was the path to outperformance. Thanks to a strong earnings season, reasonably tame inflation, and a business-friendly administration, the S&P 500 Index was the clear winner among the various asset class returns in the third quarter (see Figure 1). Chinese equity markets continued to weaken amidst trade war rhetoric and successive rounds of tariffs. Tesla, Inc.'s CEO, Elon Musk's tweets and taunting of short sellers finally caught up with him. The U.S. Securities and Exchange Commission (SEC) fined both Tesla and Musk and required his removal as chairman because of his off-the-cuff comments proposing taking Tesla private.

The average closed-end fund (CEF) managed a slight gain for the third quarter—up 0.51%, but remains lower on average by 2.12% year-to-date (YTD). Equity CEFs led the way in the quarter with an average gain of 1.52%. U.S. general equity funds were particularly strong, with the average fund up 4.07% for the quarter as they benefitted from the 7.71% total return gain the S&P 500 Index posted during the quarter. Taxable fixed income CEFs were up on average 1.30% during the quarter. Municipal CEFs continue to be hurt by the rise in both shortand long-term interest rates and finished the quarter with an average loss of 1.30%. The average municipal CEF is now lower by 4.84% YTD. Average discounts to net asset value (NAV) widened during the quarter to 6.57% from the 5.93% average which they had ended the second quarter with. They remain wider than the 4.84% discount the average CEF had as of the end of 2017. (Source: Morningstar and Bloomberg. All data is share price total return.)

Interest rates remained in an upward trajectory during the quarter as the yield on the 10-year U.S. Treasury climbed from 2.86% at the end of the second quarter to 3.06% at the end of the third quarter. Increasing interest rates were a headwind for rate sensitive fixed income assets with the Bloomberg Barclays US Aggregate Bond Index, a good proxy for the overall bond market, up 2 basis points (bps) in the third quarter and down 1.60% year-to-date (YTD). Despite higher interest rates and anemic returns in rate sensitive fixed income, high-yield bonds and senior loans have performed well. The high-yield bond index was up 2.42% in the third quarter while the senior loan index was up 1.82%. Senior loans are now up 4.03% on the year, better than all other major fixed income markets, while high-yield bonds are up 2.50% (Exhibits 1 and 2).

US Equity ETFs received the strongest estimated net inflows in Q2 2018, totaling $38 billion, rebounding from a lackluster Q1, in which estimated net inflows totaled just $1.3 billion. Sector Equity ETFs received an estimated $2.3 billion in net inflows for Q2 2018, down from $10.2 billion in Q1.

Taxable Bond ETFs received the second highest estimated net inflows in Q2 2018 with $29 billion, nearly doubling the total from Q1. Municipal Bond ETFs received nearly $2 billion in estimated net inflows during Q2 2018, setting a new high-water mark for net inflows in a calendar quarter for the category.

International Equity ETFs had the largest estimated net outflows during Q2 2018, totaling $12 billion, following a strong Q1, in which the category added $33 billion in estimated net inflows.

¹ Source: Morningstar, as of 6/30/18. Includes all US-listed exchange-traded funds, exchange-traded notes and other exchange-traded products. All net inflow and outflow numbers are estimates based on information provided by Morningstar.

The JP Morgan GBI-EM Global Diversified Index (the "Index") returned -10.40% for the 2nd quarter of 2018 as emerging market ("EM") assets came under increasing pressure. The yield on the Index rose 59 basis points (bps) over the quarter to 6.59% while similar duration 5-yr maturity U.S. Treasury bond yields rose 18bps to 2.74%.

A significant contributor to the weaker quarterly returns came from weaker emerging market currencies versus the U.S. dollar. These weaker currencies on average contributed -8.34% to the Index return. Higher emerging market bond yields contributed to the remaining negative returns.

Municipals outperform Treasuries in first half of 2018: Municipal market returns were relatively flat in first half of 2018. The Barclays Municipal Bond Index (BMBI) returned -0.25% during first half of 2018 and outperformed the Barclays Treasury Bond Index by 83 basis points (bps). For the trailing twelve months ended June 30, 2018, the BMBI had a total return of 1.56%, compared to the Barclay's U.S. Treasury Index return of -0.65%.

Rates and Fed Activity: Healthy U.S. economic statistics including payroll and wage growth, increasing inflation statistics, and U.S. Federal Reserve activity, including two FOMC rate hikes and the beginning of balance sheet downsizing, weighed on treasury prices in the first half of 2018. At June 29, 2018, the 10-year U.S. Treasury yield stood at approximately 2.86%, a 45 basis point increase from the start of the year.

Overall Municipal Issuance Declines: In the first half of 2018, total municipal issuance declined by 21.8% led by a decline in advance refunding activity. The ability for municipal borrowers to pursue advance refunding of municipal bonds on a tax-exempt basis was a casualty of the Tax Cuts & Jobs Act. YoY, refunding issuance has declined 53%.

Despite Higher Rates, Retail Demand Remains Positive: Retail demand for the first half of 2018 totaled $13.6 billion of inflows, nearly identical to the $13.8 billion for the six months prior. Since the beginning of 2017, the municipal market has only seen three months of net outflows.

Credit Trends Positive: Municipal credit quality trends remained favorable in the first half of 2018. Through June 30, 2018, using MMA data, first-time municipal defaulters totaled just 12 borrowers compared to 22 and 29 in 2017 and 2016, respectively. Moody's credit rating upgrade vs. downgrade ratios also suggest favorable credit trends, with the number of credit rating upgrades exceeding downgrades in each of the last three quarters and six of the prior seven (for the quarter ended March 31, 2018).

These posts were prepared by First Trust Advisors L. P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.

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